The Jetson Co.has an £80,000 line of credit with a 12% interest rate and a 10% compensating balance requirement which is based on the total amount borrowed.What is the effective annual
Interest rate if the ﬁrm needs £45,000 of cash for one year?

Question

Quizplus · Accepted Answer

The effective annual interest rate can be calculated by dividing the total interest paid by the actual amount of funds available for use. With a 10% compensating balance requirement on the £45,000 borrowed, the firm must leave £4,500 (10% of £45,000) in the account, effectively having £40,500 for use. The interest for one year on the £45,000 at 12% is £5,400. Therefore, the effective annual interest rate is £5,400 / £40,500 = 0.1333 or 13.33%.